The U.S. Court of Appeals for the Second Circuit vacated a District Court judgment dismissing a securities fraud class action against several major securities exchanges. The plaintiffs, including several institutional investors, alleged that the exchanges violated Exchange Act Section 10(b) and Rule 10b-5 by providing high-frequency trading ("HFT") firms with unfair advantages over other investors.

In Providence, et al., v. Bats Global Markets, the Second Circuit panel determined that (i) the exchanges are not protected from the suit by absolute immunity based on their status as self-regulatory organizations, and (ii) the plaintiffs sufficiently pled that the exchanges engaged in manipulative activity in violation of Section 10(b) and Rule 10b-5 and committed "primary violations" of securities laws. The Second Circuit ruled that the District Court erred in dismissing the plaintiffs' claims and remanded the case back to the lower court for further proceedings. The three-judge panel also affirmed the District Court's determination that it had subject matter jurisdiction over the case, rejecting the argument that the SEC's regulatory oversight over the exchange precluded private litigation.

The plaintiffs alleged that the exchanges manipulated market activity by developing products and services that disproportionately benefited and conferred trading advantages to HFT firms. The complaint focused on three products and services in particular: proprietary data feeds, co-location services and complex order types. The plaintiffs alleged that (i) high-priced proprietary data feeds facilitated a practice known as "front-running," in which HFT firms could trade on information earlier than other market participants, (ii) co-location services, which permit HFT firms to access and trade on information before it is publicly available, and (iii) complex order types that allow traders to place orders that are hidden from ordinary listings on an individual exchange. The plaintiffs charged that the exchanges offered these products and services at prices that ordinary investors could not afford, and failed to disclose the full market impact of the products and services to the investing public.

In his concurring opinion, Judge Raymond Lohier referenced an amicus brief in which the SEC argued against the assertion that the exchanges have absolute immunity. In addition to the reasons outlined in the majority opinion, Judge Lohier expressed his support for "deference to the SEC's reasonable and persuasive position" on the questions raised in the appeal. In reaching this position, he noted the SEC's "significant, specialized expertise in exchange matters and information related to the defendant exchanges."

Commentary / Adam K. Magid

Significantly, the Second Circuit's decision confirmed that the national exchanges (e.g., the NYSE and NASDAQ) are susceptible to private securities fraud claims based on a wide range of conduct, including with respect to the dissemination of market data. In so holding, the Second Circuit adopted the position advocated by the SEC in its amicus brief that the exchanges are not entitled to absolute immunity unless they are engaged in "traditional self-regulatory functions"—i.e., when they are acting as regulators of their members. If the Second Circuit's decision stands, expect more litigation (and new, novel theories of fraud and manipulation outside the context of high-frequency trading) aimed at the exchanges. To minimize this risk, the exchanges should carefully assess their practices, products and services to investors for potential antifraud liability moving forward.

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